Pattern recognition and trading decisions

PATTERN RECOGNITION AND TRADING DECISIONS CHRIS SATCHWELL McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2005 by The McGraw-Hill Companies, Inc All rights reserved Manufactured in the United States of America Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher 0-07-145480-2 The material in this eBook also appears in the print version of this title: 0-07-143480-1 All trademarks are trademarks of their respective owners Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark Where such designations appear in this book, they have been printed with initial caps McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs For more information, please contact George Hoare, Special Sales, at george_hoare@mcgraw-hill.com or (212) 904-4069 TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc (“McGraw-Hill”) and its licensors reserve all rights in and to the work Use of this work is subject to these terms Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited Your right to use the work may be terminated if you fail to comply with these terms THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE McGraw-Hill and its licensors not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom McGraw-Hill has no responsibility for the content of any information accessed through the work Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise DOI: 10.1036/0071454802 ������������ Want to learn more? 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If you’d like more information about this book, its author, or related books and websites, please click here To the memory of my parents John and Ivy This page intentionally left blank DISCLAIMER The behavior of financial instruments can be unpredictable, and investments in them, or the income they yield, can go down as well as up This book attempts to describe general techniques used by professional investors to minimize risks and improve returns, but they are based on historical experience, may be subjective, and, at best, work only for part of the time While there may be an expectation that the techniques will continue to work for enough of the time to be useful, market conditions change constantly, and there is no guarantee that they will so or that they will necessarily produce a correct or useful result for a specific decision Specific securities are referred to in this book for illustrative purposes only, and comments made should not be taken as a guide to their current condition or future prospects The attached CD ROM contains educational material, a chart pattern library, and PC-based software for illustrative purposes It comes without help or support, and it may be less reliable than commercial software packages Neither the publisher nor the author accept legal responsibility for any content of this book or associated CD ROM If accountable software is needed, an appropriate commercial product should be purchased If accountable financial advice is needed, it should be purchased from an appropriately qualified and regulated person or organization Views expressed in this work are those of the author and not necessarily reflect the corporate views of organizations with which he is, or has been, associated v vi DISCLAIMER The Global Industry Classification Standard (“GICS”) was developed by and is the exclusive property and a service mark of Morgan Stanley Capital International Inc (‘MSCI”) and Standard & Poor’s, a division of the McGraw-Hill Companies, Inc (“S&P”) and is licensed for use by [Licensee] Neither MSCI, S&P nor any other party involved in making or compiling the GICS or any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such standard or classification Without limiting any of the foregoing, in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling the GICS or any GICS classifications have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages Reproduction of GICS in any form is prohibited except with the prior written permission of S&P or MSCI Standard & Poor’s information contained in this document is subject to change without notice Standard & Poor’s cannot guarantee the accuracy, adequacy, or completeness of the information and is not responsible for any errors or omissions or for results obtained from use of such information Standard & Poor’s makes no warranties of merchantability or fitness for a particular purpose In no event shall Standard & Poor’s be liable for direct, indirect or incidental, special or consequential damages resulting from the information here regardless or whether such damages were foreseen or unforeseen For more information about this title, click here CONTENTS PREFACE xi ACKNOWLEDGMENTS xv PART ONE MARKETS AND DECISIONS Chapter Introduction Chapter Behavior of Financial Instruments Chapter Investment Psychology 33 Chapter Background to Investment Decisions: Practice and Theory 59 PART TWO FUNDAMENTAL ANALYSIS Chapter Introduction to Fundamental Analysis 81 Chapter Introductory Fundamental Analysis 85 Chapter Fundamental Analysis in Practice 105 vii CONTENTS viii PART THREE TECHNICAL ANALYSIS Chapter Introduction to Technical Analysis 125 Chapter Technical Analysis without Formulas 133 Chapter 10 Indicators: Technical Analysis with Formulas 163 Chapter 11 Trading Patterns 195 Chapter 12 Forecasting Technologies and Their Limitations 217 PART FOUR TRADING DECISIONS Chapter 13 Introduction 237 Chapter 14 Exits 239 Chapter 15 Trends 251 Chapter 16 Contrarian Strategies 267 338 Bibliography Hooke, J C Security Analysis on Wall Street: A Comprehensive Guide to Today’s Valuation Methods, University ed New York: Wiley, 1999 ISBN 0-471-36247-6 Jeffreys, H Theory of Probability, 3rd ed Oxford: Oxford University Press, 1998 ISBN 0-19-850368-7 Jones, C P Investments, 8th ed New York: Wiley, 2002 ISBN 0-471-416-41673-8 Kantz, H., and T Schreiber Nonlinear Time Series Analysis Cambridge: Cambridge University Press, 1997 ISBN 0-521-55144-7 Kaufman, P J The New Commodity Trading Systems and Methods New York: Wiley, 1987 ISBN 0-417-87879-0 Le Bon, G The Crowd: A Study of the Popular Mind Atlanta, Georgia: Cherokee Publishing Company, 1982 ISBN 0-87797-168-4 Lowe, D., and N Hazaraki Complexity Modelling and Stability Characterisation for Long Term Iterated Time Series Prediction Conference Publication No 440 Institution of Electrical Engineers (U.K.), 1997 Lowe, J Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street London: Pitman, 1995 ISBN 0-273-62214-5 ——— Value Investing Made Easy New York: McGraw-Hill, 1996 ISBN 0-07-038864-4 McMaster, R E The Art of the Trade: Mastering the Analytic and Intuitive Elements of Successful Trading New York: McGraw-Hill, 1999 ISBN 0-07-045542-2 Moore, G M Crossing the Chasm: Marketing and Selling High Tech Products to Mainstream Customers New York: HarperBusiness, 1999 ISBN 0-06-662002-3 ——— Inside The Tornado: Marketing Strategies from Silicon Valley’s Cutting Edge New York: HarperBusiness, 1999 ISBN, 0-88730-824-4 Murphy, J J Technical Analysis of the Futures Markets: A Comprehensive Guide to Trading Methods and Applications New York: New York Institute of Finance, A Prentice-Hall Company, 1986 ISBN 0-13-898008-X Neely, G Mastering Elliott Wave: Presenting the Neely Method: The First Scientific, Objective Approach to Market Forecasting with the Elliott Wave Theory Brightwaters, New York: Windsor Books, 1990 ISBN 0-930233-44-1 Nison, S Japanese Candlestick Charting Techniques: A Contemporary Guide to the Ancient Investment Techniques of the Far East New York: New York Institute of Finance, Simon & Schuster, 1991 ISBN 0-13-931650-7 Pardo, R Design, Testing, and Optimization of Trading Systems New York: Wiley, 1992 ISBN 0-471-55446-4 Press, W H., B P Flannery, S A Teukolsky, and W T Vetterling Numerical Recipes in Pascal: The Art of Scientific Computing Cambridge: Cambridge University Press, 1990 ISBN 0-521-37516-9 Pring, M J Breaking the Black Box New York: McGraw-Hill, 2003 ISBN 0-07-138405-7 ——— Investment Psychology Explained: Classic Strategies to Beat the Markets New York: Wiley, 1993 ISBN 0-471-13300-0 ——— Technical Analysis Explained: The Successful Investor’s Guide to Spotting Investment Trends and Turning Points, 4th ed New York: McGraw-Hill, 2002 ISBN 0-07-138193-7 Satchwell, C J., H James, and A H Bradley “Forecasting Values of Commercial and Residential Property Using Non-Linear Mathematical and Statistical Techniques” 2002 Joint Glasgow Conference of the European Real Estate Society (ERES) and the Cutting Edge Conference of the Royal Institute of Chartered Surveyors (RICS) Bibliography 339 Schabacker, R W Technical Analysis and Stock Market Profits: A Course in Forecasting London: Pitman, 1997 ISBN 0-273-63095-4 Schwager, J D A Complete Guide to the Futures Markets: Fundamental Analysis, Technical Analysis, Trading, Spreads and Options New York: Wiley, 1984 ISBN 0-471-89376-5 Shute, N Slide Rule London: Pan Books Ltd., 1973 Slater, J Investment Made Easy: How to Make More of Your Money London: Orion Books, 1995 ISBN 0-7528-0056-6 ——— The Zulu Principle: Making Extraordinary Profits From Ordinary Shares 5th impression, London: Texere Publishing, 2000 ISBN 1-58799-095-4 ——— Beyond The Zulu Principle: Extraordinary Profits from Growth Shares London: Texere Publishing, 1997 ISBN 1-58799-094-6 Steidlemayer, J P Steidlemayer of Markets: A New Approach to Trading New York: Wiley, 1989 ISBN 0-471-62115-3 Stamp, D Market Prophets: Can Forecasters Predict the Financial Future? London: Pearson Education, 2002 ISBN 1-903-68407-2 Stuart, A., and J K Ord Kendall’s Advanced Theory of Statistics,Vol 1, 5th ed London: Charles Griffin, 1986 ISBN 0-85264-285-7 Vetterling, W T., W H Press, B P Flannery, and S A Teukolsky Numerical Recipes Example Book (Pascal), revised ed Cambridge: Cambridge University Press, 1990 ISBN 0-521-37675-0 Wärneryd, K E Stock-Market Psychology: How People Value and Trade Stocks Cheltenham, United Kingdom: Edward Elgar, 2001 ISBN 1-84064-736-1 Wilder, J W New Concepts in Technical Trading Systems McLeansville, N C.: Trend Research Ltd., 1978 ISBN 0-89459-027-8 This page intentionally left blank INDEX Absolute momentum, 190 Acceleration factor (AF), 167 Accounting formulas, 100–104 Accounting ratios, 99–100 Actively managed mutual funds, 307 Adjusted net income, 90 Age of investor, and risk, 301 Anchoring, 20 Angel investing community, 26 Annual report, 87–90 Appel, Gerald, 72 Ascending triangle pattern, 206 Ask or asking price, 11 Assessment of risk (See Risk assessment) Asset classes, 30–31 Assets on balance sheets, 88–90 Averages, 69–70, 97, 165–166 (See also Moving averages) Balance sheets, assets on, 88–90 Bar chart, 7–10, Base building, 252 Basis for forecasting technology, 218 Bayes’ rule, 73–75, 77 Bear trends, 256, 264, 271, 276 Bearish engulfing one-bar pattern, 198, 209 Bernstein, Peter, 166 Bias/variance dilemma, 107, 220 Bid or bidding price, 11 Bishop, Chris M., 220, 226, 285 Blau, William, 270 Boiler room scam, 55 Bollinger bands, 303 Bonds, 26–28, 310 Book value, 101–102 Breakouts, 269 Broadening formation, 140 Broomhead, D S., 226 Bubble Act, 17 Building a portfolio, 309–311 Bull trends, 39–47, 40–46, 256, 264, 271, 275, 276 Bullish engulfing one-bar pattern, 198 Buy stop order, 246 Buy trail stops, 246, 250 Buying (See Entry strategies) Call, (preferred stocks), 27 Call option, 307 Candlestick chart, 7, 9, 10 Capital, 26, 288, 298, 302, 303 Cash flow in fundamental analysis, 92, 99 Castillo, Joaquin, 163, 318 CFDs (contracts for differences), 308 Charts, historic (See specific topics) Christensen, C M., 95, 96 Churning market, 259 Cialdini, Robert, 33, 105, 221 Classification of assets, 30–31 of buyers, 95–96 of markets, 158, 159, 161, 162 Closing prices, 7, 8, 9, 10, 289 Cobweb theory, 20–25, 21, 23–24, 37, 127–128, 131–132, 211 Commercial multiple time series, 232–234 Commission, 290 Common cycles or stocks, 25, 26 Companies finding competition, 118–119 life cycles, 26–28, 95–96 size, and diversification, 310–311, 319 stock selection criteria, 97–100, 111, 116–118, 117 Complexity continuation trading patterns, 197 of model, forecasting, 219–221 reversal trading patterns, 198, 199–205 of trading system, 292, 298 Compustat (Standard and Poor’s), 106 Computer-assisted technical analysis, 164 (See also Forecasting) Confirmation of trading patterns, 211–212 Conservatives, as buyers, 95 Continuation patterns, 197, 198, 265 Contracts, futures, 7, 29, 290 Contracts for differences (CFDs), 308 Contrarian strategies, 267–286 defined, 267 exit strategies, 249 fundamental analysis, 120–121, 278–279 multidimensional relative strength, 280, 285 psychological issues, 268–269 relative strength, 279–285, 281–284 341 Copyright © 2005 by The McGraw-Hill Companies, Inc Click here for terms of use Index 342 Contrarian strategies (Cont.): risk/reward, 268 technical analysis, 269–278, 272–275, 277 Convertible bonds, 26–27 Correlation, 71 Correlation matrix of returns, 285 Covariance, 70–71 Covariance matrix of returns, 285, 311–312 Cross validation of trading system, 291, 292 Crowd behavior, 34–35 Currency, as trading instrument, 309 Current ratio, 101, 102 Cyclical stocks, 94, 278, 286 DAF, 167 Data (See Information and data) Debt and fundamental analysis, 92–93, 98, 99 Debt/equity ratio, 101, 102 Decisions, investment (See Trading decisions) Demand and cobweb theory, 20–25, 21, 23–24 Demand curve, 20, 131 Derivative financial instruments, 307 Descending triangle pattern, 206 Deterministic forecasting model, 222 Developing trading systems, 292–293 Diamond top continuation pattern, 205 Dispersion, 69–70 Disruptive technology, 96 Divergences, 238, 271, 275, 276, 277 Diversification (See Portfolio diversification and management) Dividend cover, 91 Dividend value, 120 Dividends, 97 Dix, John, 18 DJIA (Dow Jones Industrial Average), 12 Dodd, David L., 85 Dollar loss stop, 248 Dow, Charles, 251, 253 Dow Jones Industrial Average (DJIA), 12 Downtrends, 138, 140, 161, 252 Drawdowns, 287–288, 294, 298, 302–303, 305 Drop-in/drop-off noise, 166, 188 Earnings, 90–91, 97 Earnings per share (EPS), 90–91, 119 Econometric forecasts, 222–223 Economic conditions, 128–130, 310 Edwards, Robert, 195, 196 Efficiency of trading patterns, 212–214 Efficient frontier, 313, 314, 315, 316, 317 Efficient model, 120 Ehlers, John, 170, 185 Eigenvalue, contrarian strategies, 285 Elliott wave theory, 253–256, 254, 330 Elton, Edwin, 311 Emotions, 34, 50, 56 Entry signals, 249 Entry strategies buy stop order, 246 buy trail stops, 246, 250 buyer classification, 95–96 monitoring positions, 330 option to buy (call), 307 portfolio management, 325, 326, 327 trading systems development, 292–293 EPS (earnings per share), 90–91 Equity curves, 287–288, 298 Equity growth, diversification, 302, 303, 304, 305, 306 Error functions, nonlinear forecast formulas, 225–226 Euphoria in markets, 14–18, 15, 19 Evidence approximation, forecasting models, 220 Exchange traded funds, 307 Exit signals, 249 Exit strategies, 239–250 diversification, 319 failure to make timely, 52, 57 indicator exits, 245 investment objectives, 240–241 investment psychology, 52 news influence, 241, 242 opportunity exits, 243 price targets, 243–245, 249 specific financial instruments, 239–240 stops, 245–249 trading systems development, 245, 292–293 value exits, 243 Expanding triangle pattern, 203, 204 Expertise, intuitive trading decisions, 60–61, 76 Expertise, trading decision judgments, 60–61 Expiration date, 307 Explicit insurance, 307–308, 319 Exploitation scams, 54–56, 57 trends, 256–265, 257, 258, 260, 263 Exponential moving average, 166, 188 “Failed” triple, 275, 276 Falling wedge, 256 Far contract, 29 Index 343 Fear, 34 Fibonacci ratios, 141, 148, 162, 244 Filter line, 186, 247–248 Filters, 185–188, 187, 189, 247–248 Financial instruments, 7–30 asset classes, 30–31 behavior of, 7–33 bonds, 26–28 cobweb theory, 20–25, 21, 23–24 common cycles, 25 defined, derivatives, 307 euphoria, 14–18, 15, 19 exit strategies, 239–240 futures as hedge, 28–29 historical view on price behavior, 12–19, 13, 15, 19 open interest, 30 price bars and charts, 7–10, 8–9 sideways markets, 20–25, 21, 23–24 speculation, 28–29 stock shares, 26–28 trends, 264, 265 volume, 10–11 Fire sale prices, 97 Ford, Henry, 20 Forecasting, 217–234 availability of variables, 218–219 basis for, 218 commercial multiple time series, 232–234 complexity of model, 219–221 econometric forecasts, 222–223 linear time series forecasts, 223–224 multiple models and error reduction, 221 multiple time series, 228, 232–234 nonlinear forecasting, 224–227, 228 price targets and exits, 243–245, 249 regulation, 234 signal vs noise, 219, 220 single time series, 227–228, 229–231 statistical considerations, 222 Formations (See Trading patterns) Frost, A J., 253 Fundamental analysis, 81–121 accounting formulas, 100–104 accounting practices, 107 annual report, 87–88 application, 81–82, 105–106 basic concepts, 85–87 cash flow, 92 company account difficulties, 81–83 competition, 118–119 contrarian strategies, 278–279 data sources, 106–107 debt, 92–93 example, car companies, 107–111, 108, 110, 112–115 future growth, 93–94 growth, 93–94 income and earnings, 90–91 investing and trading, 121 life cycles, 95–96 limitations, 120–121 monitoring positions, 329–330 new venture evaluations, 119–120 present value, 87 rational price emphasis, 81 stock screening and selection, 97–100, 111, 116–118, 117 and technical analysis, 126 trends, 265 value of dividend stream, 86 Futures, 7, 28–29 Galbraith, John Kenneth, 14–15, 37 Gap openings and exit strategies, 249 Gaussian distribution, nonlinear forecasting, 226 Geometric progression, 151, 153, 154–157 Geopolitical influences, portfolio monitoring, 329 GICS (Global Industrial Classification Standard), 119 Global Industrial Classification Standard (GICS), 119 Goals, investment, and exit strategies, 240–241 Gold/stocks/bonds triangle, 63, 64–67, 76–77 Golden ratio, 244 Good-till-canceled (GTC) stop orders, 246, 326, 329 Goodwill, 89 Gorilla buyers, 95 Grades of bonds, 26–27 Gradient, 169 Gradient descent, 226 Graham, Benjamin, 17, 18, 85–86, 87, 94, 97, 278, 310 Graham-Newman partnership, 17, 18 Granger, Clive, 221 Greed, 34 Group dynamics, investment psychology, 48–49, 56 Growth stocks, 17, 94, 278, 286 Gruber, Martin, 311 GTC (good-till-canceled) stop orders, 246, 326, 329 Index 344 Half-long, half-short positions, 309, 319 Hammer formation, 271, 273 Hammer one-bar pattern, 198, 209 Hand calculation, 164 Hanging man one-bar pattern, 198, 209 Hanging stops, 186 Haykin, Simon, 185, 226, 232 Hazaraki, N., 227 Head and shoulders top pattern, 202 Hedges, 28–29, 241 Herd behavior, investment psychology, 35–47, 38, 40–46, 56 Heuristics, 130, 133, 161, 293, 298 Historical view on price behavior, 12–19, 13, 15, 19 (See also specific topics) Hypothesis, and Bayes’ rule, 73–75, 77 methodology of successful professional investors, 53–56 motivation for investing, 47–48 portfolio monitoring, 329 pride, 51–52 reasons to study, 33–34 resolution, 53 scams and fraud, 54–56 stops, 249 time frames, 50–51 IPO (initial public offering), 26 Irrational markets, 267–269 Implicit insurance, 308–309, 319, 323 Inactivity stop, 248 Income, fundamental analysis, 90–91 Index tracker funds, 307 Indexed funds, 305, 307, 319 Indicators, 130, 163, 245, 265, 291, 292 See also Technical analysis with formulas Industry sectors, 98, 118–119, 139–140 Information and data investment psychology, 49–50, 56, 57, 232 trading decisions, 75–76, 98, 106–107, 292–293, 297–298 Initial public offering (IPO), 26 Insider action inferences, 61–62 Instability precursors, trading decisions, 62–63, 64–67 Insurance, diversification, 307–309, 319, 320 Intangible assets, 88, 89–90 Intrabar returns, diversification, 320 Intuitive trading decisions, 59–68, 64–67 Inverted hammer one-bar pattern, 198, 209 “Invest in what you know,” 302, 318 Investment decisions (See Trading decisions) Investment psychology, 33–57 character of successful professional investors, 53–56 contrarian strategies, 268–269 crowd behavior, 34–35 emotions, 34, 50 failure to make timely exits, 52, 57 group dynamics, 48–49 herd behavior, 35–47, 38, 40–46 independence of opinions, 49 information and overconfidence, 49–50 and investors, 47–56 markets, 34–47 Kantz, Holqer, 227 Kaufman, Perry, 164, 175 Keynes, John Maynard, 18, 51, 308 Knowledge, intuitive trading decisions, 60–61, 76 Kondratieff, Nikolai, 25 Kondratieff cycle, 25 Kurtosis, 70 Jones, C.P., 86 Junk bonds, 26–27 Lag, 169, 170–171, 185 Lane, George, 174, 175 Le Bon, Gustave, 34 Least-squares regressions, 166 Leather, Stephen, 55 Life cycles, products and companies, 95–96 Limitations, technical analysis, 164–165 Linear time series forecasts, 223–224 Liquidity, 11, 17–18, 246, 249, 310, 319 Long positions diversification, 318 exits planned, 239, 240, 241 futures, 28 investment psychology, 57 monitoring, 325–330, 328 sell stop order, 245–246 Trend2Noise indicator, 293–294 Lowe, D., 226, 227 Lowe, Janet, 17, 18, 100 Luddites, 96 MACD (moving average convergence divergence), 172–174, 173 Macroeconomic influences, portfolio monitoring, 329 Magee, John, 195, 196 Index 345 Management of portfolio (See Portfolio diversification and management) MAP (maximum a posteriori) technique, 220 “Margin of safety,” 310, 319 Margins, buying on, 288–289 Market decisions (See Trading decisions) Market neutral portfolio, 308 Market positions (See Long positions; Short positions) Markets classification, 158, 159, 161, 162, 265 historical view, 12–19, 13, 15, 19 information and investment psychology, 49–50, 56 investment psychology, 34–47 variability, 249, 267–269, 289, 298 (See also specific topics) Mathematics accounting formulas, 100–104 averages, 69–70, 97, 165–166 Bayes’ rule, 73–75 book value, 101–102 closing price formula, 170 cobweb theory, 127–128, 131–132 correlation, 71 covariance, 70–71 current ratio, 101, 102 debt/equity ratio, 101, 102 demand curve, 131 dispersion, 69–70 diversification, 311–314, 314, 316, 323 dividend value, 120 earnings per share (EPS), 119 error functions, nonlinear forecast, 225–226 filters, technical analysis, 185–188, 187, 189 growth from earnings, 93 inference distilled from complex data, 75–76 least-squares regressions, 166 linear-time series forecasts, 223–224 moving average, 166, 170–171, 192–194 net current asset value, 101, 102 net net current asset value, 101, 103 net quick asset value, 101, 102–103 nonlinear forecasts, 224–227 opinion variance, 71–72 overview, P/E ratio, 101, 103 parabolic time/price system, 167–169, 168 PEG ratio, 101, 104 present value, 87 price averages, 182–185, 183–184 price system/parabolic time, 167–169, 168 probability, 68–69 profit margin, 101, 103 quadratic expression, 227–228 quick ratio, 101, 103 radial basis function (RBF), 226, 227 regularized exponential moving average formula, 170–171, 192–194 regularized weighted average formula, 190–191 shareholders’ equity, 101 single time series, 227–228 smoothing constant alpha, 166 standard deviation, 70, 312–313, 314, 315, 316, 317 stochastics, 174, 175 stop width, 248 supply curve formula, 131 technical analysis, 133–162, 163–194, 170–172 total assets (TA), 101–102 trading decisions based on, 68–75 Trend2Noise, 177–178 value of dividend stream, 86 variance, 69–70, 72 Maximum entropy method, 223 McMaster, R E., 248, 259, 261 Mean, 70, 312 Megaphone pattern, 203 Methodology of successful professional investors, 53–56 MLP (multilayer perceptron), 225, 227 Modern portfolio theory, 238, 311–314, 314, 318, 323–325, 324 Momentum, 170–172, 190, 269–278, 272–275, 277, 286 Monitoring positions, 325–330, 328 Moore, G M., 95 Morgan, John Pierpoint “J.P.”, 25, 163 Motivation for investing, 47–48, 56 Moving average convergence divergence (MACD), 172–174, 173 Moving averages contrarian strategies, 270 crossovers, 162 exponential, 166 Fibonacci numbers, 162 penetrations, 188 regularized exponential moving average formula, 170–171, 192–194 sideways markets, 161 technical analysis, 141–151, 142–150, 152, 159–161, 160 in trading system, 291 window of values, 165–166, 219 Multi time series models, 228, 232–234 Multilayer perceptron (MLP), 225, 227 Multiple models and error reduction, 221 Index 346 Murphy, John, 164, 172, 195, 253 Mutual funds, actively managed, 307 Mutual information, 232 N-day pivot, 128 Narrow stop, 247 Near contract, 29 Neckline, in head and shoulders top pattern, 202 Neely, Glenn, 253 Net current asset value, 101, 102 Net income, 90 Net net current asset value or per share, 101, 103 Net quick asset value, 101, 102–103 Neumann, John Von, 163 Neural networks, 75, 224–227, 232 New venture evaluations, 119–120 New York Stock Exchange (NYSE), 12 Newman, Jerry, 17 News, as influence, 39, 40–46, 61–62, 76, 241, 242 Newsletters, 68 Newton, Isaac, 16, 51 Nison, Steve, 195, 196, 198 Noise vs signal, 219, 220 Nonlinear forecasting, 224–227, 228 Number of financial instruments, and diversification, 301, 318, 319 NYSE (New York Stock Exchange), 12 Objectives, investment, and exit strategies, 240–241 OHLC (open, high, low, close) prices, Online investor decisions, overview, Open, high, low, close (OHLC) prices, Open interest, 30, 270 Opening prices, 7, 8, 10, 289 Operating income, 90 Opinions, 49, 71–72 Opportunity exits, 243 Options, 307, 319 Origination of trading patterns, 196 Oscillators, 127–128, 163, 170, 171 Output weights, nonlinear forecast formulas, 225 Overbought/oversold concept, 270–271, 275, 279 Overconfidence, 49–50, 56 P/E (price/earnings) ratio, 91, 98, 99, 101, 103 Paper trading strategy, 290–291 Parabolic indicator, 167–169, 168, 247 Parabolic smoothing constant, 166, 167, 169 Parabolic time/price system, 167–169, 168 Parameters, trading system, 296 Patterns (See Trading patterns) PCA (principle component analysis), 285 PEG (price/earnings growth) ratio, 91, 99, 101, 104, 278 Pegging currency, 129 Penetration of trendline, 188, 199–208, 210 Pivots, 128, 131–141, 135–138, 268, 279 Portfolio diversification and management, 301–331 building a portfolio, 309–311 case study, 302–305, 304, 306 entries, 325, 326, 327 exit strategies, 319, 330–331 indexes, 305, 307 insurance, 307–309 modern portfolio theory, 238, 311–314, 314, 318, 323–325, 324 monitoring positions, 325–330, 328 optimization and efficient frontier, 313, 314, 315, 316, 317 trawling, 321–322 watch list, 322–323 (See also Financial instruments; Risk assessment) Portfolio variance, 312, 313 Portfolio weighting, 315, 316, 317 Positive feedback, 16, 18 Postpattern price behavior, 212–214 Postprocessing, contrarian strategies, 285 Power law, 153, 154–155 Pragmatists, as buyers, 95 Prechter, R R., 253 Precursors, trading decisions, 62–63, 64–67 Predicting prices (See Forecasting) Preferred stock, 27 Press, William, 223, 224, 232 Price/earnings growth (PEG) ratio, 91, 99, 101, 104, 278 Price/earnings (P/E) ratio, 91, 101, 103 Price gradient, 169 Price system/parabolic time, 167–169, 168 Price turning points, 128, 131–141, 135–138, 268, 279 Prices and price movements averages, 182–185, 183–184 bars and charts, 7–10, 8–9 closing prices, 7, 8, 9, 10, 289 differences and value investing, 85–86 direction of, 251, 261, 264 financial instruments, in geometric progression, 151, 153, 154–157 herd behavior, investment psychology, 35–47, 38, 40–46 historical view on, 12–19, 13, 15, 19 Index 347 opening prices, 7, 8, 10, 289 as reasonable, fundamental analysis, 97 reversal, contrarian strategies, 270 of shares, 27 targets and exit strategies, 243–245, 249 trends, 130, 140–141, 161 turning points, 128, 131–141, 135–138, 268, 279 Pride, 51–52, 56, 57 Principle component analysis (PCA), 285 Pring, Martin, 33, 210, 211, 291, 296 Probability, 68–69, 73–75, 77 Products, life cycles of, 95–96 Professional investors, character of successful, 53–56 Profit margin, 101, 103 Psychology (See Investment psychology) “Pump and dump” scam, 54–55 Put option, 307 Quadratic expression, 227–228 Quick ratio, 101, 103 Radial basis function (RBF), 226, 227 Rational markets, 267–269 RBF (radial basis function), 226, 227 Rea-Graham partnership, 97 Reactive indicators, 130–131 Reasonable prices, fundamental analysis, 97 Receptive field, nonlinear forecasting, 226 Recognia, 196–197 Reentry methods, 265 Regularization, 169–170 Regularized exponential moving average formula, 170–171, 192–194 Regularized momentum indicators, 168 Regularized weighted average formula, 190–191 Regulation, 234 Relative strength, 238, 279–286, 281–284 Resistance levels, 130, 134–140, 135–138, 243–244, 269, 286 Resolution, investment psychology, 53 Retrace exits, 244 Return move pattern, 202 Returns data, 98, 298 Reversal patterns, 198, 270, 286 Rising wedge, 256 Risk assessment, 287–291 capital requirements, 288 contrarian strategies, 268, 286 diversification, 301–302, 315, 318 drawdowns, 287–288 equity curves, 287–288 market variability, 289, 298 paper trading, 290–291 simulating investment strategies, 289–290, 298 (See also Portfolio diversification and management) “Risk-free fraud,” 56 RMS (root mean square) measure, 178 Roosevelt, Franklin D., 18 Root mean square (RMS) measure, 178 Rounded trading patterns, 198, 212 SAR (stop-and-reverse) trading system, 167–169, 168, 190 Saturation, nonlinear forecast formulas, 226 Scaled conjugate gradients, nonlinear forecast formulas, 226 Scams, 54–56, 57 Schabacker, Richard, 195, 196 Schreiber, Thomas, 227 SEC (Securities and Exchange Commission), 54–56 Securities, share of, Securities and Exchange Act (1933), 14, 61 Securities and Exchange Commission (SEC), 54–56 Sell stop order, 245–246 Sell trail stops, 246, 250 Selling (See Exit strategies) Share, defined, Shareholders’ equity, 101 Shooting star top reversal pattern, 198 Short positions diversification, 319 exits planned, 239, 240, 246, 249 futures, 28 monitoring, 325–330, 328 Short selling, 27 “The shout,” 55 Shute, Neville, 96 SIC codes (standard industrial classification codes), 118 Sideways markets historical, 14, 20–25, 21, 23–24, 252, 259 technical analysis, 161, 162 as trends, 262, 264, 265 Signals, 219, 220, 249, 265, 291, 292 Simple continuation trading patterns, 197 Simple pattern, 198, 209 Simple reversal pattern, 197 Simulating investment strategies, 289–290, 298, 299 Index 348 Single time series, 227–228, 229–231 Situational awareness trading patterns, 214–215 Skew, 70 Slater, Jim, 60, 61, 99, 278, 310 Slippage, 11, 240, 249, 290 Small capitalization companies, 99 Smoothing constant alpha, 166, 167, 169 Speculation, 28–29 Spread, 11 Standard and Poor’s, 26, 106, 119 Standard deviation, 70, 312–313, 315, 317, 318 Standard industrial classification codes (SIC codes), 118 Starting conditions, trends, 252–253 Statistical considerations, 222 (See also specific statistics) Steidlmayer, J Peter, 10 Stochastic oscillators, 269 Stochastic technical analysis, 174–177, 176, 190, 222 Stocks common, 25, 26 cyclical, 94, 278, 286 diversification, 310 gold/stocks/bonds triangle, 63, 64–67, 76–77 selection, 97–100, 111, 116–118, 117 shares, 26–28 Stop-and-reverse (SAR) trading system, 167–169, 168, 190 Stop line, 186 Stop orders, 240, 245–249, 250, 289 Story on stocks, and exits, 249 Straight average, 165–166 Strength, relative, 238, 279–286, 281–284 Strike price, 307 Successful professional investors, character of, 53–56 Supply, cobweb theory, 20–25, 21, 23–24 Supply curve, 20, 131 Support levels, 130, 134–140, 135–138, 243–244, 269, 286 Symmetrical triangle pattern, 207 TA (total assets), 88–90, 101–102 Tangible assets, 88 Target price and exits, 243–245, 249 Technical analysis, 125–194 cobweb theory, 127–128, 131–132, 211 contrarian strategies, 269–278, 272–275, 277 defined, 125 diversification, 319 economic relationships and certainty, 128–131 and fundamental analysis, 126 philosophy of, 130–131 pivot points (price turning points), 128, 131–132 Technical analysis with formulas, 163–194 averages, 165–166 filters, 185–188, 187, 189 hand calculation vs computer-assisted, 164 least-squares regressions, 166 limitations, 164–165 momentum, 170–172 moving average convergence divergence (MACD), 172–174, 173 parabolic time/price system, 167–169, 168 price averages, 182–185, 183–184 regularization, 169–170 regularized exponential moving average formula, 192–194 regularized weighted average formula, 190–191 stochastics, 174–177, 176, 190, 222 stop-and-reverse (SAR) trading system, 167–169, 168 Trend2Noise, 177–182, 179–181 Technical analysis without formulas, 133–162 market classification, 158 moving average patterns, 159–161, 160 moving averages, 141–151, 142–150, 152 price trends, 140–141 prices in geometric progression, 151, 153, 154–157 resistance and resistance, 134–140, 135–138 trendlines, 140–141 Technological assistance, trading patterns, 196–197 (See also Forecasting) Technology enthusiasts, as buyers, 95 Test set, forecasting models, 220 Time frame for investing, 50–51, 56 Time series commercial multiple, 232–234 linear forecasts, 223–224 multiple time series, 228, 232–234 single time, 227–228, 229–231 window of values, 165–166, 219 Timing and contrarian strategies, 267–268, 286 Top triangle pattern, 204, 205 Total assets (TA), 88–90, 101–102 Touch, trendlines, 140–141, 142–146, 210 Tradable instruments (See Financial instruments) Trading, defined, 126 Trading decisions as art and science, 59–60 contrarian strategies, 267–286 diversification and management, 301–331 Index 349 exit strategies, 239–250 fundamental analysis, 121 intuitive judgments, 59–68, 64–67 management of portfolio, 321–331 mathematics-based judgments, 68–75 for new investors, overview, 3–6, practice and theory, 59–77 risk assessment and trading systems, 287–299 stock selection, 97–100, 111, 116–118, 117 trends, 251–265 Trading patterns, 195–215 conditions preceding valid, 210 confirmation, 211–212 continuation, 197, 198, 206–208 exits based on, 245 explanations, 210–212 monitoring positions, 330 nonlinear forecast formulas, 225 origination, 196 pattern efficiency, 212–214 postpattern price behavior, 212–214 Recognia, 196–197 reversals, 197, 198, 199–205 rounded, 212 simple pattern, 198, 209 situational awareness, 214–215 technological assistance, 196–197 touch, 210 trendline penetration, 199–208, 210 volume of trading, 210 Trading ranges, contrarian strategies, 269, 286 Trading systems, 291–299, 295, 297 Trail stops, 246–247, 250 Training, forecasting model, 220, 225 Trawling, 319, 321–322 Trend-confirmation strategies, 268 Trend-following strategies, 268 Trendlines, 130, 140–141, 161, 188, 199–208, 210 Trend2Noise, 177–182, 179–181, 190, 256–262, 257, 258, 260, 293–294 Trends, 251–265 chracteristics of, and exploitation, 256–260, 257, 258, 260 defined, 252, 264 Elliott wave theory, 253–256, 254 exploitation issues, 261–264, 263 starting conditions, 252–253 usefulness, 252 Triangular continuation patterns, 198, 206–208 Triple, “failed,” 275, 276 Triple bottom pattern, 200 Triple top pattern, 199, 201 Turning points, price, 128, 131–141, 135–138, 268, 279 Twain, Mark, 217 Type II maximum likelihood, forecasting models, 220 Uncertainty, exits, 249 Universal function approximation, 225, 227 Uptrends, 140, 161, 252 Usefulness, trends, 252 Value, windows of, 165–166, 219 Value exits, 243 Value investing, 85–86, 94, 278 Value of dividend stream, 86 Variables, forecasting, 218–219 Variance, 72 Venture capitalists, 26 Ventures, evaluation of new, 119–120 Visionaries, as buyers, 95 Volume of trading, 10–11, 107, 210 Warburg, Paul M., 37 Wärneryd, Karl E., 33, 36 Watch list, 322–323 Wave wedge, as trend, 264 Wave formations, exits, 249 Web-based investing, Wedge pattern, 208 Weekly-managed portfolios, 305 “Weight of evidence” trading system, 291, 292 Whipsaw trades, 165, 259, 263 Wide stop, 247–248 Wiggle, 169, 170–171 Wilder, J Welles, Jr., 167 Williams, John Burr, 86, 87, 119 Williams, Larry, 174, 278 Window of values, 165–166, 219 This page intentionally left blank ABOUT THE AUTHOR Chris Satchwell, Ph.D., is the chief scientist for Recognia, a groundbreaking, Web-based chart analysis provider whose proprietary pattern recognition technology has automated the discovery, identification, and annotation of price chart patterns in all stock and commodity markets An internationally recognized expert in the research and development of technologies for neural networks, forecasting, and pattern recognition, Dr Satchwell writes regularly for Technical Analysis of Stocks and Commodities and other leading industry journals He was previously a company director for futures trading system developer Algorithmic Solutions 351 Copyright © 2005 by The McGraw-Hill Companies, Inc Click here for terms of use CD-ROM WARRANTY This software is protected by both United States copyright law and international copyright treaty provision You must treat this software just like a book By saying “just like a book,” McGraw-Hill means, for example, that this software may be used by any number of people and may be freely moved from one computer location to another, so long as there is no possibility of its being used at one location or on one computer while it also is being used at another Just as a book cannot be read by two different people in two different places at the same time, neither can the software be used by two different people in two different places at the same time (unless, of course, McGraw-Hill’s copyright is being violated) 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Technical Analysis with Formulas 163 Chapter 11 Trading Patterns 195 Chapter 12 Forecasting Technologies and Their Limitations 217 PART FOUR TRADING DECISIONS Chapter 13 Introduction 237 Chapter